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US wine stocks stain market darling

The woeful admission by Treasury Wine Estates that inventory levels had been grossly mismanaged and overstated is going to lead to a major rethink by the market about what this company has been doing for the past couple of years.

The woeful admission by Treasury Wine Estates that inventory levels had been grossly mismanaged and overstated is going to lead to a major rethink by the market about what this company has been doing for the past couple of years.

Under chief executive David Dearie, Treasury Wine has been telling a positive story about remaking the company, focusing on the high-end brands and installing proper management disciplines - a goal made possible thanks to winning independence from Foster's in 2011.

Treasury Wine's stellar share price performance has been a little at odds with its financial performance. In full-year 2012 its earnings rose but only because it cut costs. And in the first half of 2013 earnings fell. Investors had clearly factored in that it was on the cusp of growth.

This optimism bubble burst on Monday when it became abundantly clear its US business remains plagued by distribution issues and that behind the big picture gloss lurked a business which had failed to execute a large part of its strategy. This will cost the company a staggering $160 million.

The only piece of good news was that 2013 earnings (before inventory related writedowns) would be in line with expectations. But this reeked of disingenuousness, according to one analyst who was joined by several others querying Treasury Wine's accounting treatment in dealing with excess stock.

(Incidentally the sudden departure of Treasury Wine chief financial officer Mark Fleming barely rated a mention last month. But with the value of hindsight the announcement and his departure a day later must raise some eyebrows.)

The issues surrounding the troubles thrown up in Monday's announcement suggest the US operations remain a weeping sore. Inventory mistakes of this magnitude don't emerge overnight. Clearly wine stocks have been sitting in US retail or distributors' warehouses for a while and clearing them organically was based on wishful thinking.

It is extraordinary that $35 million of wine will be tipped down the drain and another $40 million in discounts and rebates will be undertaken to get rid of excess inventory. Another $85 million of non-cash expense will be worn due to cancelling grape contracts because of oversupply.

The mistake is partly about miscalculations about the success of new products. This is not forgivable but a bit understandable.

The more fundamental sin is that the distribution system in the US was so lacking in transparency that a slightly more forensic analysis revealed Treasury Wine appeared to have no idea (or was not admitting) what was sitting in its channels. This is traditionally referred to as channel-stuffing.

The US distributors' discovery of just-in-time inventory and logistics management meant Treasury Wine was further exposed.

Management of any retail operation has two fundamental rules - make or buy the product that the customer wants and match supply to demand (or manage inventory).

Any fashion retailer understands that its product has a shelf life of one season after which its value diminishes. It is a bit trickier with wine because shelf life varies depending on the type and quality but the theory still holds.

While inventory has been growing behind the scenes in the US, the firm's sales pitch has been focused on increasing the sale of higher-margin premium wine and expanding its footprint around the globe.

This strategy has met with some measure of success in the UK and in opening new markets in Asia. But there is no point sitting on a crow's perch if the daily operations are in disarray. Over the past two years Dearie had clearly convinced many investors and analysts to support his broader strategy or at least to get on board for what many had seen as a potential takeover target.

Treasury Wine appeared to be a ripe target in 2011 and even 2012 but this talk has died down over the past year, suggesting that share price gains reflected confidence in Dearie's strategy. He says he has now cleaned up the spilt shiraz in the US but in doing so requires the volume of commercial wine (the non-premium end) being sold to fall.

This begs the question that many investors but only one analyst asked on Monday - why don't you sell the US business? Merrill Lynch's David Errington also noted that the US business has been a problem for 13 years, and management was accountable for what appeared to be an inability to execute the strategy.

Dearie discounted any suggestion Treasury Wine would pull out of the US, which he described as a large and high-growth market.

The reduced shipments to the US will bleed into earnings in 2014 and potentially 2015.

What was once a sharemarket darling lost its gloss in Monday's trading - the share price fell more than 12 per cent by the close of trade as investors' thirst for more detail was avoided by management, which invoked the defence that it was in black-out restriction territory.

Dearie said part of the new inventory strategy was about protecting wine brands. But this news will pose a threat to the company that will require repair.

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